Pricing Deflation Risk with US Treasury Yields

Jens H. E. Christensen, Jose Lopez and Glenn Rudebusch

Review of Finance, 2016, vol. 20, issue 3, 1107-1152

Abstract: We use an arbitrage-free term structure model with spanned stochastic volatility to determine the value of the deflation protection option embedded in Treasury inflation-protected securities. The model accurately prices the deflation protection option prior to the financial crisis when its value was near zero; at the peak of the crisis in late 2008 when deflationary concerns spiked sharply; and in the post-crisis period. During 2009, the average value of this option at the 5-year maturity was 41 basis points on a par-yield basis. The option value is shown to be closely linked to overall market uncertainty as measured by the VIX, especially during and after the 2008 financial crisis.

Date: 2016
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Working Paper: Pricing deflation risk with U.S. Treasury yields (2012)
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